IRS Focuses on the FBAR

With the closing of the voluntary disclosure
program on October 15, 2009, Form TD F 90-22.1, Report of
Foreign Bank and Financial Accounts (commonly known as the
FBAR), has graduated from a little-known, often forgotten
filing requirement to a priority issue that should be at
the top of every tax return preparer’s checklist. If the
IRS was trying to raise the profile of the FBAR, it has
succeeded. But in raising the profile for tax compliance
purposes, it also raises questions about the guidance
provided with the amended FBAR in October 2008 (the 2008
instructions), the reasoning for certain disclosures, and
the appropriateness of the associated penalty regime.

The FBAR

The FBAR is an annual report that
U.S. persons file to disclose interests in foreign bank
and financial accounts (foreign accounts). Those with a
financial interest, or a signatory or similar interest, in
a foreign account are required to file. It is an
information report only. The report is not filed with the
tax return, discloses no information about the income
derived in a foreign account, and is not used to calculate
any tax obligations.

The requirement to file an
FBAR comes from the Bank Secrecy Act and related Treasury
regulations, not the Internal Revenue Code. However, the
regulations specifically delegate the FBAR’s
administration to the IRS commissioner.

IRS Focus
on the FBAR

While there has been an obligation to
file FBARs for many years, some taxpayers were not aware
of their filing obligations or overlooked them. Prior to
2009, the IRS had not aggressively enforced this filing
requirement, which likely contributed to taxpayer
complacency about FBAR obligations.

In recent
years there has been growing awareness of offshore bank
accounts worldwide. Various international groups,
including the Organisation for Economic Co-operation and
Development, the European Union, and the G-20, have
announced programs to reduce offshore tax planning that
relies on bank secrecy laws. Particular emphasis has been
placed on information exchange programs with countries
that have traditionally facilitated offshore finance
businesses. The United States has been very active in
seeking tax information exchange agreements.

At
the same time, UBS, a global financial services company,
has been accused of encouraging U.S. customers to take
advantage of Swiss bank secrecy rules by opening Swiss
bank accounts. There may be as many as 52,000 such
accounts with UBS alone, potentially hiding billions of
dollars from the IRS. This has highlighted the widespread
use of foreign accounts to evade U.S. taxes at a time of
record budget deficits, attracting the ire of Congress and
outrage on Main Street.

In 2009 alone, the IRS and
the administration collectively have announced that more
than 1,500 workers will be recruited to enforce
international tax rules, with a focus on the deferral of
income by corporations and hidden foreign accounts of
individuals.

With strong political support,
international consensus, new tools such as information
exchange agreements, and more agents available to pursue
these accounts, the IRS is ideally positioned to find
these accounts and hunt down tax evaders.

Who
Must File an FBAR?

A “person” is defined in 31
C.F.R. Section 103.11(z) as an “individual, a corporation,
a partnership, a trust or estate, a joint stock company,
an association, a syndicate, joint venture, or other
unincorporated organization or group, an Indian Tribe (as
that term is defined in the Indian Gaming Regulatory Act),
and all entities cognizable as legal personalities.”
Entities that may be disregarded for U.S. income tax
purposes may still be required to file an FBAR—for
example, a single-member limited liability company.

Where they have a relevant interest in a foreign
account, 31 C.F.R. Section 103.24 requires “[e]ach person
subject to the jurisdiction of the United States” to file
an FBAR. This definition is extraordinarily broad and
arguably could apply to any person who, for example,
transits through LAX or even enters a U.S. embassy abroad.

The 2008 instructions only require “United States
persons” to file FBARs; however, because this differs from
the definition used in the Code, it is neither clear nor
settled. The 2008 instructions define a U.S. person to be
“a citizen or resident of the United States” and “a person
in and doing business in the United States.” This second
clause was sufficiently vague that on June 5, 2009, just
25 days before the 2008 FBARs were due to be filed, the
IRS issued Announcement 2009-51, which deferred the
introduction of this second clause by one year and
retained the previous definition for the 2008 FBARs—i.e.,
domestic corporations, domestic partnerships, or domestic
trusts or estates. Subject to further modification, FBARs
due for filing in 2010 will use the uncertain definition
found in the 2008 instructions.

In relation to the
first clause, the 2008 instructions do not explicitly
state that they are importing the definition of “resident”
from the Code. However, verbal guidance from the IRS
indicates that it is relying on the residency tests in the
Code for FBAR purposes. This creates some interesting
situations. For example, a citizen who has not been
physically present in the United States at any time during
the year and has no commercial or business ties to the
United States would be required to file an FBAR.
Meanwhile, a teacher or student who is present in the
United States for the whole year under an F visa may have
no FBAR filing obligation.

It would also mean that
two resident aliens, one from a treaty country and one
from a nontreaty country, with the same type of visa and
the same number of days spent in the United States, could
be treated differently. The former could be treated as a
nonresident under a tie-breaker provision in the treaty
and therefore excluded from an FBAR filing requirement,
while the latter would be a resident and required to file.
Interestingly, if the nonresident is not an employee but
instead is carrying on a business in the United States, he
or she may be required to file the FBAR (under the 2008
instructions).

If the criterion for distinguishing
a U.S. person from a non-U.S. person for FBAR purposes is
exposure to U.S. income tax, it would seem that the FBAR
is really a tax filing and may do little to pursue the
other goals of the Bank Secrecy Act.

Reportable
Accounts

Clearly, foreign bank accounts and foreign
brokerage accounts need to be disclosed in the FBAR.
Foreign accounts include accounts with an offshore branch
of U.S. banks but exclude accounts with U.S. branches of
foreign banks. While these are relatively clear, there are
many matters that require further guidance.

For
example, the 2008 instructions require the disclosure of
“accounts in which the assets are held in a commingled
fund, and the account owner holds an equity interest in
the fund (including mutual funds).” As such, investments
in offshore mutual funds, hedge funds, and private equity
funds that involve the commingling of assets may need to
be disclosed on the FBAR. But this raises a question about
where to draw the line, especially when there is not
always agreement about the meaning of “private equity
fund” or “hedge fund”— could a public company be viewed as
a commingled fund? Because of this confusion, the IRS has
extended the time for filing an FBAR for persons with a
financial interest in or signature authority over a
foreign commingled fund (Notice 2009-62). Such persons now
have until June 30, 2010, to file an FBAR for calendar
2008 or earlier years.

In addition, this needs to
be reconciled with the exclusion of individual bonds,
notes, and stock from FBAR reporting. If a company issues
equity, the acquirer should not be required to report it,
but if a private equity fund issues equity, there may be a
reporting requirement. This is difficult logic to follow.

Bonds, notes, and stock should not be a foreign
account requiring an FBAR filing (unless they are held by
a foreign broker, in which case the brokerage account
should be a foreign account). Presumably U.S. investors
who are concerned about reporting any foreign bank
accounts may switch their investments to stock
certificates and bearer bonds and keep them in a safe
deposit box to avoid the FBAR penalty regime. Is this an
acceptable outcome, or should the IRS be modifying the
FBAR rules to address this?

The 2008 instructions
require that any account with financial institutions or
persons engaged in the business of a financial institution
be disclosed. Unfortunately, there is no guidance about
what constitutes the business of a financial institution.
Would a corporate treasury company be viewed as a
financial institution? Is a store-specific credit card
account with an offshore retailer an account with a
financial institution?

An unsecured loan to a
nonfinancial institution would not need to be disclosed on
the FBAR. However, there is no guidance distinguishing an
at-call loan from a deposit, and the meaning of “financial
institution” is critical to this example.

While
vanilla bank and brokerage accounts will clearly be
subject to FBAR requirements, there are many transactions
(only some of which are described above) in which
additional guidance is needed.

Financial Interest
and Signatory or Other Authority

U.S. persons are
required to file an FBAR for all foreign accounts in which
they have a financial interest or over which they have
signatory or other authority. The 2008 instructions
dealing with a financial interest require the owner of
record, the legal owner, or the beneficial owner of some
or all of the accounts to file as having a financial
interest. A U.S. person will also have a financial
interest in a foreign account of a corporation when he or
she owns more than 50% of the corporation’s stock (by vote
or value).

The 2008 instructions seem to require a
U.S. person to look through another U.S. person for the
purpose of this test. This creates a significant burden on
the U.S. person while merely providing the same
information to the IRS twice. For example, if a U.S.
citizen owns a greater than 50% interest in a domestic
corporation that has a foreign bank account, the U.S.
citizen would be required to file an FBAR reporting that
account (but not any related income), even though the
domestic corporation would report that same account in an
FBAR and would be liable for tax on the income. This is
another example where the FBAR rules should be considered
more practically and clearer guidance could be provided.

Voluntary Disclosure

On March 23, 2009, the
IRS announced a six-month voluntary disclosure program for
2003–2008 FBARs, giving U.S. persons an opportunity to
bring their FBAR filings up to date. As part of this
program, the IRS announced a supposedly concessionary
penalty regime in which the filer must pay 20% of the
highest account balance during the affected years. The
announcement did not give agents any authority to reduce
the penalties below 20% of the highest account balance.

While not apparent from the initial announcement,
the IRS subsequently clarified that where all the income
had been reported on the timely filed tax return (not
necessarily amended returns) and the taxes paid, the U.S.
person could file delinquent FBARs without penalty outside
the voluntary disclosure program. In this case, there
would be no penalties for late FBARs. While there is no
waiver of criminal rights to pursue U.S. persons for
late-filed FBARs, the IRS has clarified that entering this
program will allow the U.S. person to “avoid substantial
civil penalties and generally eliminate the risk of
criminal prosecution” (IRS, “Voluntary Disclosure: Questions and
Answers,” September 21, 2009, update). However, when
comparing the treatment of those who have declared the
income but not filed an FBAR with those who did not pay
their taxes, the scale of the penalty is severe. Again,
this indicates that the FBAR is predominantly being used
as a tax compliance tool, not for other law enforcement
purposes.

Penalty Program

As previously
noted, FBAR filing is required under the Bank Secrecy Act.
The related regulations, 31 C.F.R. Section 103, deal
mainly with suspicious activity reports from financial
institutions, which are generally used to combat financial
crimes, including money laundering, where the balance in
the account often represents the reward for criminal
efforts. Therefore, it is not surprising that the
penalties are calculated by reference to the balance in
the account and can be as much as 50% of the highest
balance of the account each year. In addition to these
penalties, there are also criminal penalties of up to
$500,000 and 10 years in jail.

However, the Code
has its own penalties, which tend to be calculated by
reference to the taxes avoided, not the balance of the
account. This leads to a more equitable result—i.e., where
significant taxes are avoided, the penalties are
significant, and if small amounts of tax are avoided, the
penalties tend to be modest. While the IRS has authority
to use the Bank Secrecy Act penalty regime, it is
troubling that it has decided to use this penalty regime
for tax purposes.

There are numerous examples of
how this approach can lead to inequity. For instance,
assume that a U.S. person wants to buy an Italian villa
for $1 million. The U.S. person establishes an Italian
bank account and, one week prior to the closing, funds
that account with $1 million. The interest income over the
one week, net of bank fees, is $100. The account is then
closed immediately after the purchase. Under the voluntary
disclosure program, the penalty for failing to file the
FBAR would be $200,000, which is completely out of
proportion with the amount of tax at issue ($35). If the
account were discovered outside the voluntary disclosure
program, the penalty could be $500,000.

Another
situation might be one in which a U.S. person has a
foreign securities account with $1 million of capital
generating 15% annually. If that person files an FBAR but
discloses only $50,000 of the income in his or her U.S.
tax return, the penalty should be $26,250 per year (75% of
the tax payable). If the same person failed to file the
FBAR, the penalty increases to as much as $526,250 per
year. If the account derived 1%—i.e., $10,000— the
voluntary disclosure penalty would be $200,000 plus the
tax, interest, and accuracy penalty. If the account
derived no income, there would be no penalty.

Similarly, where a U.S. person with signatory authority
but no economic interest in the account fails to file, the
initial guidance from the IRS indicates that the U.S.
person could be subject to penalties calculated as a
percentage of the balance in the account in which he or
she has no economic interest (although the IRS seems to
have now modified this position). To give itself time to
address this situation, the IRS has extended the time for
filing an FBAR for calendar 2008 or earlier years for
persons with signature authority over, but no financial
interest in, a foreign account to June 30, 2010 (Notice
2009-22).

Next Steps

The IRS invited
comments in relation to the 2008 instructions, and at the
time of this writing those comments had not been made
public. One thing is clear: The 2008 instructions need to
be clearer about who should be filing an FBAR and which
accounts should be disclosed. Fundamental to this point is
that Treasury needs to determine whether the FBAR is
predominantly a tax filing. If it is, the definitions used
in the 2008 instructions should be reconciled (or
replaced) with known tax terms that are defined and
understood.

There should also be a careful
evaluation of the penalty regime. When a penalty regime is
arbitrary and inequitable, it discourages compliance. If
the IRS believes the penalties in the Code are inadequate
to discourage people from hiding foreign accounts, it
should ask Congress for greater penalty powers to be used
within limits Congress may define. In any event, the IRS
should give its agents the authority to remit FBAR-related
penalties when they are excessive and disproportionate to
the income not disclosed.

The views expressed in this item are the views of the
author and not necessarily the views of Friedman LLP.

EditorNotes

Michael Koppel is
with Gray, Gray & Gray, LLP, in Westwood, MA.

Unless otherwise noted, contributors are members of or
associated with CPAmerica International.

For
additional information about these items, contact Mr.
Koppel at (781) 407-0300, or mkoppel@gggcpas.com.

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